CHAPTER
8
Completing the
Operating Cycle
Learning Objective 1
Account for the
various components
of employee
compensation
expense.
Describe the Employee
Compensation Time Line
Payroll
Compensated
Absences
Stock
Options
and
Bonuses
Time
Postemployment
Benefits
Pensions
and Postretiremen
t Benefits
Other
than
Pensions
Payroll
 Salaries and wages earned by employees in the
current period. What are the correct journal
entries?
Recording
the
payment
of
 Accounting for salaries of $2,700:
this payable
is similar to
When employees
work:
Salariesjournal
Expense. .entry
. . . . . . .to
. . .record
. . . . . . . . .2,700
Salaries Payable . . . . . . . . . . . . . . . . . .
2,700
payment of every payable.
When wages are
The
payable
is
debited
paid:
Salaries Payable. . . . . . . . . . . . . . . . . . . . . . 2,700
and
cash
is
credited.
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2,700
 However, accounting for salaries and related
payroll taxes is never this simple.
Federal and state
income
Withholdings
taxes.
Which taxes must employers withhold
from Social
employees’
salaries
Security
(FICA) and wages?
taxes.
Voluntary or contractual
withholdings (union dues,
They are notmedical
additional
expenses to the
insurance
premiums,
and charitable
employer since
the employee
pays the
donations).
taxes. The business
acts as agent to
assist in the collection of funds for the
government or organization.
Salaries Expense Entry
Sally Wage works for you and earns
$32,400 annually. Make the
appropriate journal entry for Sally’s
January salary.
Salaries Expense. . . . . . . . . . . . . . . . . . . . . . 2,700
FICA Taxes Payable, Employee. . . . . . .
180
Federal Withholding Taxes Payable . . .
486
State Withholding Taxes Payable . . . . .
243
Union Dues Payable . . . . . . . . . . . . . . . .
68
Salaries Payable . . . . . . . . . . . . . . . . . . .
1723
To record Sally Wage’s salary.
Payroll Tax Expense Entry
Now that the appropriate journal
entry is made for Sally’s wages,
make the entry to record your
company’s portion.
Payroll Tax Expense. . . . . . . . . . . . . . . . . . . 278
FICA Taxes Payable, Employer . . . . . . .
180
Federal Unemployment Taxes Payable.
30
State Unemployment Taxes Payable. . .
68
To record liabilities associated with Sally
Wage’s salary.
Compensated Absences
Matching principle
The expense associated with the compensated
absence must be accounted for in the period in
which it is earned by the employee.
Therefore, the expense is estimated.
Salaries Expense . . . . . . . . . . . . . . . . . . . . 125
Sick Days Payable . . . . . . . . . . . . . . . .
125
To recognize accrued sick pay.
Journal entry when the sick day is actually taken:
Sick Days Payable . . . . . . . . . . . . . . . . . . . 125
Various Taxes Payables. . . . . . . . . . . .
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . .
To record payment of sick day net of FICA,
federal, and state taxes.
35
90
Describe Bonuses and Stock
Options
 Employees, generally top
management, may have the option to
purchase stock in the future at a price
specified today.
 Generally, the stock is presently
selling at an amount below the option
price.
 The objective is to provide
management with an incentive to
effectively run the company in such a
way that the stock price increases.
Bonuses and Stock Options
Your firm met its target goals this year.
Your President, Mr. Will Fences, is
therefore entitled to a bonus. His
annual salary is $1 million and his
bonus is 15 percent, payable at the end
of the year. Make the appropriate
December 31 journal entry for the
bonus.
Salaries Expense . . . . . . . . . . . . . . . . . . . . 150,000
Various Taxes Payables. . . . . . . . . . . .
60,000
Bonus Payable . . . . . . . . . . . . . . . . . . .
90,000
To record bonus earned by Mr. Will Fences.
Post-employment Benefits
 Those benefits incurred after an employee has
ceased to work for an employer but before that
employee retires.
 Examples: severance packages, retraining costs,
education costs.
 Journal entry when estimated salaries are $2,000:
Salaries Expense . . . . . . . . . . . . . . . . . . . . 2,000
Benefits Payable. . . . . . . . . . . . . . . . . .
2,000
To record post-employment benefits for laid-off employees.
 When paid, a journal entry is made to reduce the
payable and to record the cash outflow.
Define Pensions
 Compensation received by an employee after retirement.
 Defined contribution plan.

Employer sets aside money to be paid following
retirement.
 Employee gets what was contributed plus the
earnings.
 Defined benefit plan.
 Benefits based on number of years worked.
 Employee gets whatever benefit is defined
in the plan.
 Company attempts to determine costs to be paid in the
future and records an estimate in the current period.
Learning Objective 2
Compute income tax
expense including
appropriate consideration
of deferred tax
items.
Taxes on Operations
What other taxes are companies
responsible to pay?
Sales Taxes
Property Taxes
Income Taxes
Example: Sales Taxes
Michael’s Mowers sold a
lawnmower for $340. What is the
journal entry assuming the state
charges a 5 percent sales tax?
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sales Revenue. . . . . . . . . . . . . . . . . .
Sales Tax Payable. . . . . . . . . . . . . . .
357
340
17
From sale of lawnmower, including 5% sales tax.
Example: Property Taxes
The City of Greenlawn assesses property
taxes on land and buildings. Michael’s
Mowers pays its property taxes on a
calendar-year basis and owes Greenlawn
$6,200 for 2004. Make Michael’s appropriate
journal entry.
12/31/03 Property Tax Expense . . . . . .
Property Tax Payable. . . . .
6,200
6,200
To record property tax expense and liability to
Greenlawn City.
Example: Income Taxes
Michael’s Mowers pretax income is
$385,000. Its income tax rate for 2003
for both federal and state is 30 percent.
Prepare an adjusting entry at year-end
showing the company’s tax expense.
12/31/03 Income Tax Expense . . . . . . . .115,500
Income Tax Payable. . . . . . .
115,500
To record income tax expense and tax liability
on $385,000 pretax income for 2001 using a
30 percent effective tax rate.
Learning Objective 3
Distinguish between
contingent items that
should be recognized in
the financial statements
and those that should
be merely disclosed in
the financial statement
notes.
Contingencies




Contingency: An event that
may or may not occur.
Accounting standard setters
say proper disclosure depends
upon the assessed outcome.
Terms used to describe
contingencies: probable,
reasonably possible, and
remote.
A firm must obtain objective
assessments and then
account for those events
based on that assessment.
Contingent Liabilities
Term
Probable
Definition
The future event is likely
Accounting
Estimate the amount
to occur. of the
contingency and
make the appropriate
journal entry; provide
detailed disclosure in
the notes.
Reasonably The chance of the future
possible
event occurring is more
than remote but less than
likely.
Provide detailed
disclosure of the
possible liability in
the notes.
Remote
No disclosure
required.
The chance of the future
event occurring is slight.
Learning Objective 4
Understand when
an expenditure
should be recorded
as an asset and
when it should be
recorded as an
expense.
Describe the Expense/Asset
Continuum
Office
Supplies
Used
Expense
Repairs
Research and
Development
Land
and
Building
Asset
Expense or Capitalize?
Why the Debate?
Michael’s builds a new $1 million store. Should it simply
show this as an expense or capitalize it as an asset?
 If Michael’s chooses not to capitalize, the company’s financial





statements will be misstated.
The income statement in Year 1 will have too much expense.
The income statements for Years 2 through 20 will contain too
little expense.
Potential investors may invest elsewhere because of the low
net income figure resulting from the large expense.
The balance sheet will not show an item that is expected to
benefit future periods.
Bad resource allocation decisions could result.
Learning Objective 5
Prepare an income
statement
summarizing
operating activities
as well as other
revenues and
expenses,
extraordinary items,
and earnings per
share.
Income Statement
Put these major components
of an Income Statement in
correct order:
 Net sales revenue
 Net income
 Sales revenue
 Cost of goods sold
 Operating expenses
 Operating income
2
6
1
3
4
5
Income Statement Format
Revenues
– Cost of goods sold
= Gross margin
– Selling expenses
– General and administrative expenses
= Operating income
+/– Other revenues and expenses
= Income before taxes
– Income tax
= Income after taxes
+/– Extraordinary items
= Net income
Define Other Revenue and
Expenses
Those items incurred or
earned from activities that are
outside of, or peripheral to, the
normal operations of a firm.
For example, Michael’s
Mowers sponsored a local little
league team. Its expense for
uniforms may be shown under
“Other Revenues and
Expenses.”
Define Extraordinary Items




Reserved for reporting special non-operating gains
and losses.
Restrictive and includes only those items that are:
unusual in nature
infrequent in occurrence
material in amount
Separate so financial statement
users can know they are one-time
or nonrecurring events.
Examples: losses from floods,
fires, earthquakes.
Define Earnings per Share




EPS is required on the income statement.
If extraordinary items are included, EPS
figures are reported
on income before extraordinary items,
on extraordinary items, and
on net income.
Allows potential investors to compare
profitability across firms of different sizes.
How do you do the calculation?
Net income
Average number of shares outstanding